I had to do a brief chat about the Global Financial Crisis, “mistakes” that were made, and the role of the international financial architecture, for a organisation I’m not naming with people I’m not naming. It was Chatham House rules, but nothing particularly rough was said – so I’m more not naming anything as I like to let people’s minds run wild! Anyway, here are the notes I wrote for myself in preparation – make of them what you will.

Intro

I’ve been asked to talk about the ‘mistakes made’ with regards to the Global Financial Crisis, and the ‘financial architecture. Let us start off by not assuming a mistake per se, but in asking what type of narrative describes what we experienced – from that we can try to describe what can be seen as a mistake. Furthermore, the term “architecture”, or “infrastructure”, also presupposes something about the nature of financial institutions – and directly implies it is something that needs to be built, making it sound as if we need a central organisation to do it. While there might be some truth in that, it is not where I’d prefer to start with any discussion.

Focusing on supranational, undemocratically determined, institutions for “solutions” to a policy problem misses the point – yes the world is integrated and national level institutions need to coordinate more, but focus needs to be on national policy when discussing mistakes. As Dani Rodrik says, it is up to nations to keep their house in order, not other countries. If anything the crisis in Europe shows the shortcoming of supranational regulation, given the true democratic mandate is a national one.

Even after a crisis the key thing we need to ask is what narratives fit our data, so we can build an understanding of what the impact of (national level) regulatory policy could be. For an example of how this matters, say that if a financial crisis is like an earthquake – in that case we may believe that policy actions that help to insure people against the costs are appropriate. Instead, assume that a financial crisis was due to the risky choice of individuals and organisations – then we would want policy that makes these people bear the costs of their choice.

The “truth” is between these, so let’s talk about these narratives.

The financial system

The GFC should not have changed our view of broad view of what financial institutions are.

The purpose of the financial system is as a market – as place where individuals and groups who want to save match up with individual and groups who want to borrow. The institutions in the middle are financial intermediaries – and their role can be viewed in a number of ways:

By screening the quality of borrowers, and doing so with the economies of scale of a large institution, they provide a cost effective service for those who want to save.

Due to their scale, financial institutions are able to diversify risk – which individual depositors may not be able to do if they lent directly.

Maturity transformation: Financial institutions, due to their size, are able to “lend for the long term” and “borrow for the short term” as long as depositors have faith in the institution – this ‘maturity mismatch’ creates value for both lenders and borrowers.

There are broader points about banks offering a ‘risk-free rate of return’, determining the money supply, inflation-protection of savings, and offering financial services – these are important issues when thinking about regulation, but are a bit beside the point when we are focused on the GFC directly!

The question we are focused on is around the “mistakes” made by policy during the Global Financial Crisis. We can split mistakes into two categories:

Mistakes in terms of policy during the crisis.

Mistakes in terms of regulation and policy in the lead up to the crisis.

This separation is very important, as it helps to give us a perspective on the way policy and institutions can be changed to reduce the chance of a similar crisis – and also helps us to think about the cost of these regulatory changes!

The catalyst of the crisis

When thinking about the crisis kicking off, a lot is made of subprime mortgages, and non-recourse mortgages (so the debt is against the collateral in the house, not pinned to the individual borrowing). Although housing is an important asset class (and the structure of mortgages did influence the way the market adjusted), it is more useful to think about these events in more general terms if we want to consider the financial infrastructure more generally.

Lehman Brothers and the failure of AIG

Crisis had kicked off in mid-2007 with the housing market slowing in the US and BNP Paribus (in France) running into a liquidity crisis in August.

Northern Rock in February 2008 and the Bear Sterns event in March 2008 – still debate about whether the bailout exacerbated risk taking in the lead up to September, or whether it did prevent a crisis as of March.

Failure of LB after Barclays refused to buy at the last minute in September 2008. Led to the near failure of AIG, an insurance company that had essentially been insuring a sizable chunk of the shadow banking system.

“Oil price shock”. The steep run up in oil prices during 2007/08 was also a major, and often underplayed, cause of the global recession in late 2008/early 2009. The magnitude of this shock was underplayed at the time, and was part of the reason why the slowdown heading into during 2010/11 was also more intense than anticipated (oil prices were rebounding at this time).

The response

After it became apparent that the failure of Lehman Brothers had done irreparable damage to AIG, faith in the entire financial system collapsed. The rapid nature of the response by global economic authorities is captured in a book called “the alchemists” by Neil Irwin. This gives a good run down of what happened through the narrative of the US, UK, and European central bankers at the time.

A combination of monetary policy easing, currency-swap agreements between central banks, significant new liquidity facilities (eg accepting lower quality collateral when giving loans), and direct purchases of some institutions (where shareholders value was essentially wiped out – but bondholders retained their claims) were all implemented in the wake of the Lehman Brother’s crisis. Together, these policies helped to stabilise the financial system.

Fragile by design or nature? Why not both.

The response to the crisis was largely appropriate. Actions by the Federal Reserve and US Treasury helped to stem what was a “bank run” in the shadow banking system.

Shadow banking system: “Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions – Bernanke”

The idea of a bank run in the shadow banking system was popularised by Gary Gorton. He noted that one of the key reasons the crisis had such a broad impact on the financial market is because of the nature of shadow banking, and the way the line was blurred between commercial and shadow banking – namely that commercial banks would use the shadow banking sector for a significant amount of their interbank lending and borrowing activity. One of his views was that the shadow banking system evolved to avoid regulation (rather than being the result of lax regulation per se) – which gives him the conclusion that we simply need to extend regulation to capture the shadow banking system.

Of course, this is far from easy – trying to regulate a specific industry is like trying to squeeze a lemon with your hand and keep it contained, the harder you squeeze the more bits leave your hand completely.

When faced with a bank run in a situation where large parts of the financial system are inherently “solvent” but facing problems of “liquidity” a government can improve outcomes by saying they will not let the organisation fail.

Illiquidity: When an institution would, if holding its assets to maturity/selling at a ‘normal’ point of time, would be able to cover its liabilities. However, during a crisis the institution is unable to sell its assets at a sufficiently high value to meet its liabilities.

Insolvent: When an institutions liabilities would exceed the value of their assets in normal economic circumstances.

A bank run leads to a coordination failure for solvent firms with liquidity issues – if people were not pulling their funds out of a solvent financial institution, then it is in investors interest not to take out their money. But if everyone is taking out their funds, the institution is forced to sell assets at “firesale” prices, making it in the investors interest to pull out as soon as possible! This illustrates that the importance of the bank run is closely related to the idea of maturity transformation (or maturity mismatch) discussed above!

Note: It can be hard to separate the two – given that insolvency may only become clear during a crisis! When Bagehot came up with this in in the 19th century he was clear that insolvent institutions should be allowed to fail, but modern regulators realise judging who is “insolvent” is unclear.

Mistakes leading up to the crisis?

However, we can’t just think of these issues at a point in time – the existence of a guarantee in the case of failure changes how we all view institutions. If such a bailout is expected, depositors with financial institutions are willing to accept a lower rate of return – as a result, the entire financial system ends up taking on more risk.

This is a version of “moral hazard” and stems from the financial system (and depositors) being implicitly or explicitly insured by central government.

While there is this policy view of risk, there is also the more general ideas of “externalities” and “systemic risk”.

The key concern here is, even if firms were appropriately taking into account risk, they do not take into account how their failure could impact upon other institutions. In this case, there are two issues of note:

A type of externality where the risk taking of one financial institution negatively impacts on other institutions.

A “cascading failure” in financial institutions due to the interdependence of firms – implying that in the face of a “systemic event” the failure of one institution could lead to the failure of the entire financial system. This is similar to the idea of bank runs – and again a clear difference between “liquidity” and “solvency” needs to be taken into account.

However, it is clear that the policy and the market risks play off each other – the general unwillingness of policy to let institutions fail incentivises risky lending which makes the financial system more fragile, both in terms of having “too big to fail” (TBTF) firms and “too interdependent to fail” (TITF) firms. [Note this is very different to the Great Depression, where it was the fact firms were too small, and so were all treated the same independent of actual quality, that helped drive mass bank runs – these issues are often unclear!].

We can only say there is a “policy mistake” if we are clear about the goals of policy. There are some key points that come from our narrative:

Some of the advantages of financial intermediation also increase fragility – implying there is, along some margin, a trade-off between efficiency and stability (eg maturity mismatch)

Although we have split the failures into three categories (regulatory, externality, systemic event) the three are intrinsically related and can feed off each other.

We need to be clear about the difference between insolvency and illiquid institutions – financial institutions should be able to fail, and if an entire financial system was “insolvent” the decision about what to do is actually a conversation of who should bear the burden for the loss.

More generally our “pre-emptive” solutions depend strongly on what we believe the cause of the crisis is – if financial firms require regulation, regulation should be tied strongly to a perceived failure.

In this context, clear capital ratios for banks have attractive properties – current policy about matching maturities, LVR limits, core funding ratio, risk-weighted capital ratios all justified in this light. However, questions about how much the central bank should be “determining risk tolerance” for private institutions – something that makes the Admati & Hellwig (in The Bankers New Clothes) suggestion of a general capital/equity ratio more attractive, as it is based largely on the view that it is the “favouring of debt financing to equity financing of lending” driving a lot of the issues down the line (TBTF, risky behaviour). Eg firms have the incentive to become TBTF solely because of the implicit subsidy on debt financing, through the lender of last resort and tax status of this funding.

However, capital requirements will still lead to excessive risk taking – although they may be helpful they are not the silver bullet that some may claim. A recent paper by Josh Hendrickson (http://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2014/2/v34n1-7.pdf) points out that one of the key issues is to ensure that bank shareholders face losses that are commensurate with the risks they took on in the face of a negative outcome – his suggestion is to replace limited liability with contingent liability.

Note that Josh’s suggestion would help to deal with the typical moral hazard issue, but not necessarily with the fundamental issues of systemic risk – and expectations of a policy response in the face of a systemic event (which then leads us back to moral hazard). It is along these lines that the RBNZ is trying to clarify rules with the Open Bank Resolution.

An inability to get lenders and borrowers to see eye-to-eye: The case of Europe

However, the crisis did not end up finishing at this point. After the global economy recovered sharply during the second half of 2009, events in Europe took a life of their own. There are two clear narratives that given for the fact that global economy continued to struggle in the intervening five years:

A failure of monetary/government policy. This includes the delays to implementing forward guidance, the fiscal tightening in a number of countries, and the issues of “coordination” with regards to policy between countries.

Policy and regulatory failure in Europe that kept acting as surprise “negative shocks” for the rest of the world.

The European Crisis was in many ways a different beast, as the concern was about whether individual nation’s government would pay bondholders. An unwillingness to define whether the burden of “bad government debt” would fall upon bondholders, bank shareholders, or taxpayers created a situation of uncertainty – and led to a seizing up in financial markets.

Disappointingly, the events in Europe didn’t teach us particularly more about the Global Financial Crisis. Instead, the primary additional (and extremely costly) lesson of the European Crisis was simply that the institutions involved in European governance are weaker than we had realised.

Matt, a very nice post. Have you heard of the gambling for redemption literature?

The Greeks initially did a fine job in gambling for redemption. Squeezing huge subsidies and debt write-offs by threatening to default! The Irish played by the rules, guaranteed bank bond holders to which that had no obligation and got screwed.

Arellano, Conesa, and Kehoe explain that the deep and prolonged recession in many Eurozone countries creates an incentive the gamble for redemption. This is betting that the recession will soon end. Sell more bonds to smooth government spending in the interim, and, if the economy recovers, reduce the enlarged debt.

Under some circumstances, this policy is the best that a government can do for the citizens of its country, but it carries a risk! If the recession continues too long, the government will have to stop increasing its debt or default on its bonds.

Policies that result in high interest rates on government bonds and high costs of default provide incentives for a government to reduce its debt and avoid sovereign default. · Policies that result in low interest rates and low costs of default provide incentives for a government to gamble for redemption. The interventions taken to date by the EU and the IMF – lowering the cost of borrowing and reducing default penalties – encourage Eurozone governments to gamble for redemption.

Interesting stuff. Although I am most of the way there, I am not sure I buy the final bit:

“Policies that result in low interest rates and low costs of default provide incentives for a government to gamble for redemption. The interventions taken to date by the EU and the IMF – lowering the cost of borrowing and reducing default penalties – encourage Eurozone governments to gamble for redemption.”

The key thing is that the behaviour of the national government here reminds me of Lehman Brothers in the year leading up to their crash. They realised they were insolved and made highly leveraged bets knowing that if it blows up it doesn’t cost them anything – but if it works they don’t go bankrupt! In that environment it doesn’t matter what the interest rate is, it is the asymmetry of treatment and expectations of a bailout.

In the case of government sovereign debt we would have a similar dynamic where governments did not expect they would have to take on the liability. As you say, the idea of reducing default penalties will worsen this, but the actual cost of credit may not be an issue.

There were significant institutional issues in Europe, and I have much less of a background looking at that than looking at the specifics of the US end of the GFC. I’ll have to have a peek at the book sometime 😉

Given that Gary Gorton was heavily involved in constructing AIG’s disastrous CDS-sales business, perhaps he’s not the best guy to get your view of the GFC from. I think Perry Mehrling’s view is a bit more considered. The simple bank-run diagnosis is a off the mark and increasing capital ratios is not obviously going to prevent a market and funding liquidity breakdown.

I did know Gorton was involved in that way, but would have viewed someone involved in the creation of the vehicles as having a unique insight into what is going on. However, I can also see how it is possible he may be involved in some “ex-post justification” of his work.

Yes, exactly, I knew someone with your keen eye for trade-offs, preferences and incentives would see that! That’s the book, when you do get around to reading it please let me know what you think, I’m sure you’ll have a different view from me. Actually he has two courses both good. Another good one is John Cochrane’s Asset Pricing course.